Reverse OTM put calendar spread, criticize my strategy

T

Timetwister

I have seen that if you wanted to hedge a long position using puts, the higher the strike of the put, the less you pay per day if you buy puts that expire distant in time. And the opposite happens with OTM puts. If you wanted to hedge your position with OTM puts, it's cheaper per day if you buy those that expire as soon as possible. This effect is higher as you get more ITM and OTM respectively.

For example, with ES at about $2098.75 right now, if you wanted to buy $1950 puts, if you had to choose any of the next 3 expirations, you'd have the following choices:

-December 4 (expires in 2 days ignoring today) for $0.125 ($0.0625 per day).
-December 11 (expires in 7 business days ignoring today) for $0.725 ($0.1036 per day)
-December 18 (expires in 12 business days ignoring today) for $1.975 ($0.1646 per day).

So you'd choose the first option, as it's the cheapest form of insurance.

After seeing that I thought: "Why not selling the second expiration while buying the first one"? Decay from the second one, in absolute terms, is higher than what I pay per day to hedge my sold position.

So in this case, I'd sell the December 18 put for $1.975 while buying the December 11 one for $0.725. If nothing changes, in 5 days the sold one will be worth $0.725, and the bought one, $0.125; so I'd win 1.975-0.725+0.125-0.725=$0.65

I want the price to rise as much as possible (so the sold option, which is more expensive, losses value), and implied volatility to drop (for the same reason).

So my question is whether it makes sense to try to profit from the fact that OTM options that expire distant in time are "overvalued" in terms of premium/number of days until expiration, in comparison to those that expire sooner.
 
they are more expensive because there is a greater chance they will be in the money.

so you have to have the view that the puts a likely to not be in the money compared to now.

a good example where your structure would make sense, is if you think VRX will go to $50 by the end of this year (and if it doesn't then it will never go to $50).
 
Tt: You need to move beyond the premium/days calcs and look at the behavior of the spread over time and with volatility scenarios. "Overvalued" will be defined by your volatility forecast and not absolute premium.

Caveat: Reverse Calendar's are a very unique exposure that I have yet to really profit from. If my understanding is correct, the ideal situation is enter during "buy on the dip" and exit close to the ATM when price recovers.

However, the front month tends to drop in volatility more than the back month after the recovery. I think betting that the front month IV drop will be muted is a bad gamble. (Though, we have had an increased occurrence since August.(ie SP and retail)

Might be a good strategy for bear rallies or extreme price crashes. Overall, a strategy that you really won't be using much because the appropriate situation is rare or extremely risky.

Newwurldmn: Please correct any misconceptions that I may have.
 
xandman said:
I think betting that the front month IV drop will be muted is a bad gamble.
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Bad gamble why? Do you mean in the actual situation, because you consider IV is lower than it "should be"?

Anyway, I wasn't asking about opening this specific position, it was just an example, you obviously prefer IV to be as high as possible when entering the position, as you profit from a drop in IV.
 
Timetwister said:
Should they be more expensive also in terms of premium/day? Because that part is what doesn't make sense to me.
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a 10% otm option that expires tomorrow vs a 10% otm option that expires 10 years from now are very different. the stock can sell off 5% tomorrow and then 5% the next day and the 10 year option will be atm while the tomorrow option will have expired worthless.
 
Timetwister said:
Bad gamble why? Do you mean in the actual situation, because you consider IV is lower than it "should be"?

Anyway, I wasn't asking about opening this specific position, it was just an example, you obviously prefer IV to be as high as possible when entering the position, as you profit from a drop in IV.
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An IV collapse is more likely when stocks bounce back up. And, it is more pronounced in the front months.

It is not an absolute. High (ish) IV is preferable, but excessively high IV could portend to excessively high realized volatility.
 
newwurldmn said:
a 10% otm option that expires tomorrow vs a 10% otm option that expires 10 years from now are very different. the stock can sell off 5% tomorrow and then 5% the next day and the 10 year option will be atm while the tomorrow option will have expired worthless.
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OK, I think I understand it now, thanks. As time until expiration increases, there are more ways to make the price drop X%.

What's the reason why in the case of ATM options those more distant in the future have a lower premium/remaining days ratio?
 
xandman said:
An IV collapse is more likely when stocks bounce back up. And, it is more pronounced in the front months.

It is not an absolute. High (ish) IV is preferable, but excessively high IV could portend to excessively high realized volatility.
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Well, in this case I'm long the front month (week in this case), so that's not a problem. It is indeed, but because the sold position is much higher in nominal terms, so the IV of the first one would have to increase much more than the second one to win money that way (and I'd have to close the bought put before expiration, to profit from that IV increase).
 
The position is bullish and not much payoff for the risk.

If ES dropped a bit - the options are still OTM - you'd be stuck with an unhedged put at a loss.

I like reverse cals, but generally trade ATM with an expected move one way or the other.
 
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